chapter 15 interest rate derivative market. chapter objectives n describe the types of interest rate...

CHAPTER

1515 Interest Rate

Derivative

Market © 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Describe the types of interest rate swaps available

Describe the risks of swaps Identify other commonly used interest rate

derivative instruments Describe the globalization of swap markets

BackgroundBackground

Definition: Interest rate swap is an agreement between two parties to exchange one set of interest rate payments for another

Usually an exchange of a stream of fixed-rate interest payments for floating-rate payments

Characteristics Over-the-counter trading—coordinated and

negotiated by financial institution Contracts less standardized than other derivatives

like futures and options

Provisions of a SwapProvisions of a Swap

The notional principal value to which the interest rates are applied to calculate the interest payments

The fixed interest rate The formula and type of index used to

determine the floating rate The frequency of payments, such as every six

months or every year The lifetime of the swap


Payments equal the differential multiplied by the notational amount used to calculate payments

No payment of notional principal Payments made based on net amounts Swaps used to manage risk or to speculate Market imperfections help explain the

existence of swaps If used for speculation, can involve losses


Example of two financial institutions, one in the U.S and one in Europe used to illustrate swap concepts

A U.S. financial institution with liabilities more rate-sensitive than assets is affected adversely by rising interest rates

A European financial institution has access to long-term, fixed-rate funds but makes floating rate loans and has the opposite exposure as compared to U.S. institution

Exhibit 15.1 An Interest Rate SwapExhibit 15.1 An Interest Rate Swap

Short-TermDeposits

Intereston Deposits

Long-TFixed-Rate

erm Loans

Fixed InterestPayments on Loans

Fixed-RateLong-TermDeposits

Intereston Deposits

Floating-RateLoans

Floating InterestPayments on Loans

U.S.Depositors

U.S.Borrowers

EuropeanDepositors

EuropeanBorrowers

EuropeanFinancialInstitution

U.S. FinancialInstitution

FixedInterest

Payments

FloatingInterestPayments


If interest rates increase and the U.S. and foreign institution negotiate a swap, the U.S. institution gets higher interest payments as rates rise to help offset the increased cost of funds

If interest rates decline then the foreign institution makes lower interest payments to the U.S. which helps offset the lower interest payments the European institution receives on loans


Both institutions limit the potential benefits they might receive if rates moved in their favor—a hedge U.S. bank forgoes potential benefits from rate

declines European bank forgoes any potential benefits from

rate increases Different kinds of swaps are possible which

vary in the degree to which they cover the interest exposure and allow institutions to capture benefits if rates move in their favor

Participation by Financial InstitutionsParticipation by Financial Institutions

Institutions including banks, pension funds and insurance companies exposed to interest rate risk use swaps to manage it

Intermediaries match up firms Charge fees May provide a credit guarantee, for a fee

Dealer Takes a counterparty position to serve clients Results in risk exposure unless it has an offsetting

swap with another client

Types of Interest Rate SwapsTypes of Interest Rate Swaps

Plain vanilla swap involves periodic exchange of fixed-rate payments for floating-rate payments

Basic exchange of payments for the U.S. and European institution given in the example information

LIBOR or London Interbank Offer Rate used as the as the index

Exhibit 15.3 Plain Vanilla SwapExhibit 15.3 Plain Vanilla Swap

1 2 3 4 5 6 7 8

Scenario of RisingInterest Rates

End of Year

Fixed Outflow Payments

Floating Inflow Payments

1 2 3 4 5 6 7 8

Scenario of DecliningInterest Rates

End of Year



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A forward swap is an exchange of interest payments that does not begin until some future point in time

Used if an institution is currently insulated against rate risk but anticipates risk beginning at a future time

Swap period is delayed but institution locks in future terms

Locks in at the prevailing rates based on expectations about future interest rates

Exhibit 15.5 Forward SwapExhibit 15.5 Forward Swap

1 2 3 4 5 6 7 8




End of Year

ForwardSwap IsArrangedat This Time

00

Swapping of PaymentsBegins at This Time

1 2 3 4 5 6 7 8

Scenario of RisingInterest Rates Floating Inflow Payments


End of Year

at This T

ForwardSwap IsArranged

ime TSwapping of Payments

Begins at This ime

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Callable swaps are a swap option that allows counterparty with fixed payments to terminate prior to maturity

U.S. institution in the example could terminate swap if rates decline and then capture the benefits

Party with the right to terminate pays a premium in the form of a higher fixed rate

May also involve a termination fee

Exhibit 15.6 Callable SwapExhibit 15.6 Callable Swap

1 2 3 4 5 6 7 8

End of Year

1 2 3 4 5 6 7 8

End of Year



Fixed Outflow Payments*

Option is exercised toterminate the swap atthis time, because interestrate trend is downward.


Floating InflowPayments

Fixed OutflowPayments*

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Putable swaps allow the counterparty with floating-rate payments to terminate prior to maturity

European institution in the example could terminate swap if rates increase and then capture the benefits

Party with the right to terminate pays a premium in the form of a higher fixed rate

May also involve a termination fee

Exhibit 15.7 Putable SwapExhibit 15.7 Putable Swap

1 2 3 4 5 6 7 8

End of Year

1 2 3 4 5 6 7 8

End of Year



Fixed OutflowPayments*



Fixed Outflow Payments*

Option is exercised byrecipient of fixed outflowpayments to terminatethe swap at this time, becauseinterest rate trend is upward.

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Extendable swaps allow the fixed-for-floating party to extend the swap period

Benefits from the ability to extend a current swap rather than negotiate a new swap at the prevailing market rates in existence when the initial swap matures

This feature involves a higher price May have to pay fees if swap is extended

Exhibit 15.8 Extendable SwapExhibit 15.8 Extendable Swap

1 2 3 4 5 6 7 8

End of Year

1 2 3 4 5 6 7 8

End of Year



Fixed OutflowPayments


Fixed OutflowPayments

Floating InflowPaymentsAt this time, the institution

would likely extendthe swap period. At this time, the institution

would likely decide not toextend the swap period.Le

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Zero-coupon-for-floating swaps involve a fixed-rate payer that makes a single payment at the maturity of the swap

Floating-rate payer makes periodic payments An example is a U.S. institution with short-

term deposits funding zero coupon bonds The risk is that an interest rate increase causes

the bond prices to fall and increases the cost of funds on the liability side of the balance sheet

Exhibit 15.9 Zero-Coupon-For-Floating Exhibit 15.9 Zero-Coupon-For-Floating SwapSwap

1 2 3 4 5 6 7 8

End of Year

1 2 3 4 5 6 7 8

End of Year


• A Single Lump-SumFixed Outflow Payment




• A Single Lump-SumFixed Outflow Payment

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Rate-capped swaps exchange fixed-rate payments for floating-rate payments that are capped and involve up-front fees

Example of U.S. and European firm European firm may want to limit its possible

payments with the cap and know what its maximum payments will be

U.S. firm may believe rates will not go above cap and if they do, swap’s effectiveness is limited

Exhibit 15.10 Rate-Capped SwapExhibit 15.10 Rate-Capped Swap

1 2 3 4 5 6 7 8

End of Year

1 2 3 4 5 6 7 8

End of Year


FloatingInflowPayments

FixedOutflowPayments

This TimeAgreeing to Cap

Payer of Fixed Outflow PaymentsReceives Premium at for

CapLevel


Purple Line ReflectsFloating Inflow PaymentsIf a Cap Did Not Exist


CapLevel

Payer of Fixed Outflow PaymentsReceives Premium at This Timefor Agreeing to Cap

Floating Inflow PaymentsBased on Cap


Equity swaps involve the exchange of interest payments for payments linked to the degree of change in a stock index

Example Company with a fixed 7% interest rate Swaps a fixed rate for rate of appreciation in an

index over a period of time If index appreciates by 9% a year, differential is

2% For use by portfolio managers

Other Types of Interest Rate SwapsOther Types of Interest Rate Swaps

Rate swaps to accommodate financing needs Corporations with varied debt ratings swap fixed

for floating interest payments Swap parties benefit from considerable differential

in capital market rates for parties Brokered by financial institutions who may bear

credit or default risk Tax swaps

Firm with expiring loss carryforwards swaps with Firm expects future losses but has large gains from

operations this year

Exhibit 15.11 Interest Rate SwapExhibit 15.11 Interest Rate Swap

Variable-Rate Payments at LIBOR + ½%

Fixed-Rate Payments at 9½%

Investors inFixed-Rate

Bonds Issuedby Quality Co.

Risky Co.Quality Co.

Fixed-RatePaymentsat 9%

Investors in Variable-RateBonds Issuedby Risky Co.

Variable-RatePayments

at LIBOR + 1%

Risk of Interest Rate SwapsRisk of Interest Rate Swaps

Basis risk is the chance that the index does not move in perfect tandem with the floating-rate instruments

Credit risk exists because one of the firms may not meet its payment obligations but this is minimized If counterparty 1 defaults it does not make a

required payment Counterparty 2 would stop all subsequent

payments

Risk of Interest Rate SwapsRisk of Interest Rate Swaps

Credit risk concerns exist for those that guarantee swaps Regulators are considering how to respond Large growth in swaps market so this concern will

receive continued attention Sovereign risk is the potential adverse effect

from a country’s political conditions that could prevent one party from fulfilling its obligations

Pricing Interest Rate SwapsPricing Interest Rate Swaps

Prevailing market interest rates determine swap rates

Availability of counterparties influences pricing If there are numerous potential counterparties it

increases the chance of negotiating favorable terms

This will change as economic conditions change Credit and sovereign risk also influence prices

Factors Affecting the Performance of Factors Affecting the Performance of Interest Rate SwapsInterest Rate Swaps

Swap performance is affected by several underlying forces

Indicators monitored by participants in the swaps markets include any that would affect interest rates U.S. economic conditions International economic conditions Monetary and fiscal policy

Interest Rate Caps, Floors, and CollarsInterest Rate Caps, Floors, and Collars

Interest rate caps offer payments in periods when a specified interest rate index exceeds a specified ceiling interest rate Payments based on the amount by which the

interest rate exceeds the cap times the notational principal

Fee paid up front Purchaser is an institution adversely affected

by rate increases while seller expects stable or declining future rates


Interest rate floors offer payments in periods when a specified interest rate index falls below a specified floor rate.

Used to hedge against lower interest rates Seller gets the up-front fee but has an ongoing

obligation to make payments if the rate falls below the floor


Collar involves the simultaneous purchase of an interest rate cap and sale of an interest rate floor

Cap generates payments if interest rates rise Use fee from selling floor to buy the cap If rates drop, the institution has the ongoing

obligation created by the sale of the interest rate floor

Globalization of Swap MarketsGlobalization of Swap Markets

Counter-parties for interest rate swaps extends beyond United States, where interest rate changes may vary

Manufacturing corporations from various countries also engage in swaps

Interest rate swaps are denominated in many currencies

Lack of information and credit risk concerns reduced if intermediaries back payments


Currency swap is an arrangement in which currencies are exchanged at specified foreign exchange rates and at specified intervals

Used by firms to hedge their risks from foreign currency exposure caused by inflows and outflows denominated in different currencies

Currency swaps available in several variations and may involve intermediaries


Hedging bond payments with currency swaps involves Firm 1 issuing a bond denominated in euros to fund its euro operations

Firm 1 receives euros in the course of business that would be used to repay the bonds

Investors in the euro market do not know Firm 1 very well

Firm 1 swaps with Firm 2, a company that wants to issue dollar debt but is not well known by investors who buy dollar-denominated debt


Risks of currency swaps involve the same risks as other interest rate swaps Basis risk occurs if using a related currency or if

price movements are not perfectly correlated Credit risk Sovereign risk

chapter 15 interest rate derivative market. chapter objectives n describe the types of interest rate...

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